Busang: River of Gold (A) Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Busang: River of Gold (A) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Busang: River of Gold (A) case study is a Harvard Business School (HBR) case study written by Jeffrey Bell, Christine Dinh-Tan, Philip Purnama, Debora L. Spar. The Busang: River of Gold (A) (referred as “Bre Gold” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Joint ventures, Public relations.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Busang: River of Gold (A) Case Study

In 1995, Bre-X Minerals, a tiny Canadian mining firm, struck gold. Deep in the heart of the Borneo jungle, it discovered what appeared to be one of the world's largest and most cost-effective gold deposits. Almost immediately, the firm's stock price shot upwards and its managers were besieged by eager investors and would-be partners. They also became mired in the relationship-based politics of Indonesia. To mine the gold, and reap the benefits, Bre-X management must establish several critical relationships with financial partners outside Indonesia and with political and business partners inside the country. Yet figuring out with whom to ally itself is no easy task. The case describes how Bre-X's management reviews its options and evaluates the strategic advantages and risks of key relationships.

Case Authors : Jeffrey Bell, Christine Dinh-Tan, Philip Purnama, Debora L. Spar

Topic : Global Business

Related Areas : Joint ventures, Public relations

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Calculating Net Present Value (NPV) at 6% for Busang: River of Gold (A) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005948)	-10005948	-	-
Year 1	3467284	-6538664	3467284	0.9434	3271023
Year 2	3958580	-2580084	7425864	0.89	3523122
Year 3	3949205	1369121	11375069	0.8396	3315829
Year 4	3244927	4614048	14619996	0.7921	2570286
TOTAL			14619996		12680260

The Net Present Value at 6% discount rate is 2674312

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Profitability Index
2. Internal Rate of Return
3. Payback Period
4. Net Present Value

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Bre Gold shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
2. Timing of the expected cash flows – stockholders of Bre Gold have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Busang: River of Gold (A)

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Global Business Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Bre Gold often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Bre Gold needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10005948)	-10005948	-	-
Year 1	3467284	-6538664	3467284	0.8696	3015030
Year 2	3958580	-2580084	7425864	0.7561	2993255
Year 3	3949205	1369121	11375069	0.6575	2596666
Year 4	3244927	4614048	14619996	0.5718	1855298
TOTAL					10460249

The Net NPV after 4 years is 454301

(10460249 - 10005948 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10005948)	-10005948	-	-
Year 1	3467284	-6538664	3467284	0.8333	2889403
Year 2	3958580	-2580084	7425864	0.6944	2749014
Year 3	3949205	1369121	11375069	0.5787	2285420
Year 4	3244927	4614048	14619996	0.4823	1564876
TOTAL					9488713

The Net NPV after 4 years is -517235

At 20% discount rate the NPV is negative (9488713 - 10005948 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bre Gold to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Bre Gold has a NPV value higher than Zero then finance managers at Bre Gold can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Bre Gold, then the stock price of the Bre Gold should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Bre Gold should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

Understanding of risks involved in the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Busang: River of Gold (A)

References & Further Readings

Jeffrey Bell, Christine Dinh-Tan, Philip Purnama, Debora L. Spar (2018), "Busang: River of Gold (A) Harvard Business Review Case Study. Published by HBR Publications.